April 22nd, 2011
The bonds that PIMCO’s Bill Gross sold to take a 3% short position in the Treasury market may have found a buyer in Doubleline’s Jeffrey Gundlach. In a conference call with investors last week, Gundlach said that Treasury prices would rise in the near term, once QE2 expires on June 30. Follow up:
Follow up:For over a year, Gundlach has forecast a “long-term bottoming process” in government bond yields. Last week he said he remains committed to that outlook.
If you are a buy-and-hold investor with a 10-year horizon, Gundlach said, you should position your portfolio with the expectation of inflation. But he doesn’t expect inflation to unfold any time soon. “I am not in the camp that believes Treasury rates are about to rocket higher because of the end of QE2,” he said. “I think just the opposite, actually.”
The $236 billion in Gross’ Total Return fund makes him the world’s largest bond investor, dwarfing the $6.1 billion in Doubleline’s Total Return fund. But Gundlach’s performance record over the past decade, including the results at his previous employer, TCW, has surpassed Gross’. That helps explain why Doubleline’s Total Return fund just celebrated its first anniversary by establishing a new record for assets gathered in in its first year and why Gundlach’s comments are closely followed by market observers.
I’ll look at the assessment of the economic and market conditions that underlies Gundlach’s contrarian position in the Treasury market, and I’ll also discuss why another prominent bond manager, Hoisington Investment Management, reached the same conclusion as him but for different reasons.
The elephant in the kitchen
A common theme in Gundlach’s analyses over the last several years has been increasing total credit market debt as a percentage of GDP, which peaked at 365% in 2009 and had dropped only slightly to 345% as of the end of 2010. The slight dip was caused by consumer deleveraging, but the underlying trend remains.
Gundlach called this debt the “elephant in the kitchen,” because it dominates the fundamentals underlying the investment markets.
The challenge investors face, Gundlach said, is figuring how that debt will be repaid, while at the same time funding the liabilities of federal entitlement programs, without debasing the dollar.
The present level of federal borrowing will detract from future economic growth and productive investments, Gundlach said. “That is not a good framework, and this is why we are having so much trouble now in Washington, DC,” he said.
In the 1940s, federal receipts as a percentage of debt, as shown in the chart below, were as precarious as they are now, with debt equal to ten times receipts. Gundlach said that imbalance was corrected with tax increases, with tax receipts rising from 5% to 20% of GDP in the 1940s. As a result, debt decreased to merely two times receipts in 1980. But that was when consumer leveraging accelerated, putting us back where we were 70 years ago.
The problem, Gundlach said, is if interest rates go up it would cause a “really difficult fiscal situation” with interest expenses. “We really need to get this in order if we are going to be on a sound footing,” he said.
Gundlach noted that the Office of Management and Budget (OMB) has estimated that the government’s fiscal position will improve slightly over the next four years, but he said he is skeptical of those forecasts.
Slow growth ahead
The Federal Reserve, thanks to its quantitative easing policies, is now the largest purchaser of government debt, supplanting China for that distinction. The latest round, a $600 billion bond-buying program dubbed QE2, is set to end on June 30. “That is going to be a moment of truth for the US economy,” Gundlach said.
Without further monetary stimulus and with conservative fiscal policies like the $38.5 billion in budget cuts recently passed by Congress, Gundlach said the US economy will weaken substantially.
“If we are going to stop stimulating the economy to the tune of $1.65 trillion a year, it is blatantly obvious that the economy will suffer pretty dramatically if a true budget-cutting exercise were to take place,” Gundlach said.
Gundlach called the direction of proposed fiscal policies an “austerity program,” which by definition means lower economic growth. “It's a little late to be starting that, because it is going to be really painful,” he said. “My view is that it is going to be so painful that it is going to be abandoned, and that is when the inflationists might be right.”
One likely outcome will be increased taxes on individuals, particularly wealthy ones. Gundlach said that taxes would need to rise from 20% to 35% of GDP to solve federal debt problems. He considers an increase of that magnitude likely, but he said that top marginal tax rates could increase to 60%.
The market reaction to prior quantitative easing events
Turning to Gundlach’s interest rate forecast, he said it is critical to review the market’s reaction to various monetary policies over the last several years, as shown in the graph of the 10-year Treasury bond below:
QE1 was announced (the first red arrow on the left) amid and because of a global banking panic, Gundlach said. The result was a continued decline in rates that ended in December of 2008.
When the purchases actually began, though, bond yields started to rise. That was counterintuitive, Gundlach said, because government’s buying actions should have pushed prices up and yields down. His explanation was that bond investors get nervous when there is a strong inflationary-biased policy. While government buying supported the prices of newly issued securities, investors holding the other $8 trillion of Treasury bonds were unsettled and pushed yields on the 10-year from 2% to 4%.
When QE1 was extended, yields rose even further.
On March 31, 2010, purchases from QE1 ended and bond yields collapsed. Gundlach said this was probably because the stimulus that quantitative easing represented was withdrawn, and that hurt the economy. The withdrawal of QE1 may have also made bond investors feel better that inflationary policies were no longer being pursued.
“The implementation of quantitative easing has produced exactly the opposite market behavior that some people intuitively expected,” he said.
When QE2 was announced, yields bottomed, and when bond purchases began, yields rose.
“The idea that ending QE2 would necessarily mean a rate rise flies in the face of the bloodless verdict of the market,” he said, “which is that when quantitative easing was in place, bond yields rose, and when it was taken off it led to weaker economy and rates falling. I think that is going to happen again.”
Gundlach also said that the start of QE1 triggered a rally in equities, and that rally was amplified when QE1 was extended. When QE1 ended, stocks fell. Stocks rallied again when Bernanke made his speech in Jackson Hole announcing QE2 and rallied again when the buying program began. Gundlach said he expects that pattern to repeat, and that stocks will go down when QE2 ends. “The discounting for that should be starting in the relatively near term,” he said.
Gross has not spoken publicly about his decision to short the Treasury market. But in his last monthly commentary, he offered the likely explanation – his disgust with Congress’ inability to address its debt burden and, in particular, federal entitlement programs. He wrote that the inevitable outcome would be higher inflation or its equivalent, a declining dollar.
Gross also wrote that the government could manage its debt “stealthily via policy rates and Treasury yields far below historical levels – paying savers less on their money and hoping they won’t complain” – and that policy direction supports Gundlach’s position.
More support for a bond rally
Texas-based Hoisington Investment Management supervises over $4 billion in fixed-income assets. In their most recent commentary, the firm’s principals, Van Hoisington and Lacy Hunt, were sharply critical of the Fed’s quantitative easing policy. They argued that it encouraged speculation, slowed economic growth and “eviscerated” the standard of living for the average American family.
On their last point, Hoisington and Hunt cited the “misery index,” which combines the unemployment and inflation rates. This metric was less than 7% prior to the financial crisis. Since the Fed announced QE2 in the second quarter of last year, it has risen from 9.1% to an estimated 14% in the current quarter.
“The Bernanke Fed provides fresh confirmation that trying to substitute higher inflation for lower unemployment harms the economy,” they wrote.
Hoisington and Hunt concurred with Gundlach, arguing that the end of QE2 will bring about lower interest rates. It will not restore the Fed’s balance sheet to a “reasonable size,” they said, but it will reinforce the actions of the other major central banks (the ECB, the People’s Bank of China, and the Bank of England), which have all commenced raising interest rates.
“The global upturn in inflation will reverse, thereby placing the global economy on a more stable footing,” they wrote.
Hoisington and Hunt advised investors to move gradually into Treasury securities, although they warned (as did Gundlach) that the economy would slow in the second half of this year. Deflation will be the dominant theme, creating a favorable environment for holders of long-dated Treasury bonds. “Positioning for an inflation boom will prove to be disappointing,” they said.
The likelihood of QE3
What if Gundlach, Hoisington and Hunt are correct and the economy slows appreciably in the second half of this year? Tighter Fed policy, rising interest rates and higher commodity prices could combine to bring about that outcome.
In an email exchange, Gundlach wrote that slower growth could also be a consequence of “a well-intentioned attempt to rein in the out-of-control budget deficit through tax hikes and spending cuts. “
If so, then pressure will build for another round of quantitative easing.
“When a debt-logged economy experiences even a moderate growth slowdown, the deflation winds begin to blow,” Gundlach wrote. “When that happens, the population will be screaming for QE3, and so they will get it.”
For active managers like Gundlach, the challenge will be to anticipate the Fed’s moves, assess market sentiment and correctly position their portfolios on the yield curve – a challenge that Gundlach has more than met over the last decade.
In light of Gundlach’s advice, however, a long-term buy-and-hold investor should simply position his or her portfolio for inflation.
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